Financial Advice for a Home Equity Line of Credit

A home equity line of credit is best used to finance big-ticket items.

Establishing home equity is central to the wealth-creation process, as it describes the difference between your property value and any associated mortgage loans. Home equity grows as you pay off housing debt and property values increase. From there, you may borrow against this equity with a home equity line of credit (HELOC) as a financial planning tool. Be advised that a HELOC presents distinct risks to your bottom line and is best used for special situations.

Identification

The HELOC is often referred to as a second mortgage. Home equity lines of credit are secured loans, which are backed by your home equity as collateral. Because of this security, banks are willing to offer low interest rates for home equity lines in comparison to credit card agreements. Credit card loans are unsecured loans, where banks rely on good faith for customers to make payments. Similar to credit cards, home equity lines of credit are revolving debt. Revolving loans grant borrowers the power to increase debt balances owed up to a certain credit limit. Because of this revolving feature, a HELOC will charge variable interest rates that shift according to the economic environment.

Features

Banks set interest rates on individual home equity lines of credit according to risk. Borrowers who carry higher debt levels against fewer assets on their personal balance sheets are more likely to pay higher interest rates. Lenders review the credit history of each applicant before making approval decisions. It is a good idea to review your credit report before applying (see Resources) so you can correct any errors. Beyond interest payments, banks generate additional income from numerous fees associated with the home equity line of credit product. These fees go toward property appraisals, closing costs and account maintenance. The property appraisal helps banks determine the amount of equity in your home, while closing costs help pay attorneys, taxes and title fees. According to the Federal Reserve Board, these fees may total hundreds of dollars.

Considerations

Interest payments made on home equity lines of credit are generally tax-deductible expenses. During tax season, lenders submit IRS Form 1098 to borrowers for a summary of the prior year’s HELOC interest payments. From there, you may file Schedule A to itemize the total interest payments from all mortgages related to your primary residence and any vacation home. The mortgage interest deduction can effectively lower costs for maintaining the HELOC.

Strategy

Because of their high fees, home equity lines are more so ideal to finance large transactions of at least $10,000, such as college tuition payments and business start-up costs. The HELOC may also allow you to save interest costs on expensive credit cards, through refinancing. Refinancing is a debt management technique, where people take out new loans at low interest rates to pay off and replace existing debt.

Warning

The HELOC can create additional financial strain if borrowed funds are spent on consumer goods. Distressed homeowners who fail to make loan payments are susceptible to foreclosure. In foreclosure, lenders seize a particular property and auction it off for cash.

About the Author

Kofi Bofah has been writing Internet content since 2010, with articles appearing on various websites. He is the founder of ONYX INVESTMENTS, which is based out of Chicago. Bofah enjoys writing about business, finance, travel, transportation, sports and entertainment. He holds a Bachelor of Science in Business Management from the University of North Carolina at Chapel Hill.